Corporate taxation and its discontents

It’s a tangled mess and a creature of Congress. Guess who’s trying to fix it.

If a fundamental test of good law is whether it treats like people in a like manner, the tax code fails. A jumble of intertwined, sometime contradictory edicts, experts blame the corporate tax code, especially, for warping commercial trade and driving revenue into foreign coffers (See: Apple, Ireland). Now, Congress says it will build a better corporate tax code.

Citing the complexity, loopholes and inefficiencies, Senate Finance Chairman Max Baucus, D-Mont., and ranking member Orrin Hatch, R-Utah, declared: “America’s tax code is broken.” In the letter addressed to colleagues, they ask congressmen for ideas to make repairs.

When it comes to fixing the corporate tax code, UF Law alumni and faculty lie at the nexus of policy and practice.

Mark Prater (LLMT 87), chief tax counsel and deputy staff director for Senate Finance Republicans, said Congress is interested in the topic in part because the world has changed so dramatically since the last major tax reform during President Ronald Reagan’s administration.

“Business is much more global now,” Prater said. “Borders are much less of a factor. … U.S. companies tend to have future growth based in foreign markets. The world has changed very dramatically on the business side, and our tax code is still rooted in the world of 1986.”

He said the committee has been working on a nonpartisan basis for three years to meet its goal: a system to meet Reagan’s still-relevant criteria of efficiency, fairness and simplicity. Practicing tax lawyers and tax professors are alive to the problems surrounding corporate tax law.

“What good tax lawyers do is help their clients conduct their business affairs and investment activities while minimizing their tax burden in ways that are legal,” explained corporate tax lawyer Abraham “Hap” Shashy (JD 73). “It has not changed structurally, but it has continued to grow in complexity. Much of what is wrong in our tax system comes from the complexity of it.”

And the complexity puts tax lawyers with a working knowledge of its arcana in a powerful position.

“I can describe it (the corporate tax code) concisely only using jargon that is unintelligible to anybody other than a tax policy expert,” said UF Law tax Professor Martin McMahon, the James J. Freeland Eminent Scholar, who teaches corporate, income and partnership taxation.

McMahon offered an illustration of the power wielded by tax lawyers, which also conveniently serves as an example of the code’s inequity.

“Assume that a corporation is going to be acquired in a merger. There are 10 shareholders, all equal. Four of them paid almost nothing for their stock, but it’s very valuable. Six of them paid more for their stock than it is currently worth. I could structure a transaction to give stock to those that were going to make a profit and give cash to those who were going to have a loss,” McMahon said.

“Those who got cash get to put the loss on their tax return. Those who got stock don’t have to put the gain on their tax return. Perfectly legal,” he said. “It’s right there in all the rules. It’s not even a loophole.”

So the tax code has become complicated and unfair.

But here’s the bad news for tax lawyers: Simplifying the code could reduce demand for their services, according to McMahon and Shashy.

Corporate tax system alternatives and the status quo Worldwide consolidation system: Requires U.S. corporations to pay taxes on the worldwide income of all facets of the corporation, including all of its foreign subsidiaries. Credit is granted for foreign taxes paid.

Territorial system: Corporations are taxed only on income derived within the taxing jurisdiction. The U.S. government would only be able to tax profits from business conducted in the U.S.

Current system: A hybrid of worldwide and territorial systems, according to Senate Finance tax counsel Mark Prater (LLMT 87). The U.S. taxes corporations on worldwide income at a 35 percent rate (though many tax benefits lower the effective rate), and corporations are allowed a credit for taxes paid to other countries. The system is a hybrid because U.S. tax on overseas income is immediately due on certain types of income or otherwise when income is brought home.

“After the 1986 Tax Reform Act, a lot of tax lawyers lost their jobs because it shut down a lot of real estate tax shelters and other kinds of tax shelters,” McMahon said. “The demand for tax lawyers plunged for a couple of years. It rebounded, and it’s probably as strong as ever now.”

In fact, Congress has imposed more than 15,000 changes to the code since the Tax Reform Act of 1986, according to the Baucus-Hatch letter.

“The result is a tax base riddled with exclusions, deductions and credits,” the senators write. “The complexity, inefficiency and unfairness of the tax code are acting as a brake on our economy.”

McMahon says these tensions have come into focus with the rise of economic globalization.

“One has to remember that most of those rules were put into place when U.S. corporations did very little business outside of the U.S.,” McMahon said. “The statutory rules governing international taxation in particular simply have not kept pace with modern business and financial transactions.”

Today, more than 70 percent of the world’s purchasing power is outside of the U.S., according to the International Trade Administration’s website.

Prater said tax reform is particularly relevant on the corporate side because the U.S. is a leader in intellectual property law. But he said policymakers must be careful how they tweak the laws.

“We could make U.S. companies a lot less competitive relative to their foreign counterparts if we impose the tax burden on U.S. companies just by virtue of being U.S. based,” Prater said.

Prater drew a dire picture of the consequences.

“That competitive imbalance could cause out-migration from place of incorporation first. Eventually headquarters, management, and research and other activities that are now U.S.-based could follow,” Prater added. “Moreover, U.S. companies could become attractive targets for foreign acquisition.”

McMahon said Congress is the main reason the tax code no longer functions efficiently, and that businesses are merely applying rules enacted by Congress to their best advantage.

He said many corporations lobby against reforming the corporate tax law because they are afraid of losing special provisions from which they benefit. They are “pouring untold millions of dollars into political contributions lobbying to have all of the profits of their foreign subsidiaries completely exempt from U.S. taxation forever, even if it’s brought back to the U.S. One-hundred percent of the problem is caused by Congress.”

McMahon is skeptical that Congress will pass reform legislation, but he favors worldwide consolidation, requiring U.S. corporations to pay U.S. taxes on the worldwide income of all facets of the corporation, including all of its foreign subsidiaries.

UF Law Assistant Professor Omri Marian said worldwide consolidation is one of the best options for tax reform, but that a territorial tax system also is a viable course of action, assuming proper safeguards against tax avoidance are introduced.

“I prefer worldwide consolidation primarily for fairness reasons because I think it means – at least for the United States – that companies of the United States that operate globally will be subjected to the same system as U.S. companies that do not operate globally,” he said.
He said that under worldwide consolidation, Apple would be taxed in the U.S. on its worldwide income, including income earned by its foreign subsidiaries.

Under the current system, Apple’s able to shift much of its income to pocketbook Irish subsidiaries where the income remains untaxed, despite the fact that all of Apple’s research and development is done in Cupertino, Calif.

Another reform alternative is to shift to a territorial system under which the government would only tax incomes sourced in the U.S.

McMahon warned that shifting to a territorial system would risk even more corporations moving outside of the country.

But Shashy, a UF Law Board of Trustees member and former chief counsel of the Internal Revenue Service, argued that the U.S. should take a cue from other nations that use the territorial system. Shashy said a territorial system would enhance capital flows into the U.S. by allowing multinational companies to move cash without tax penalties. America’s current tax system impedes this type of transfer, he said.

“The fact that we don’t have a territorial tax system — and the fact that we are different from most of the territorial countries in the world — has become more apparent,” Shashy said. “The U.S. at this moment is out of step with the tax systems in most of the rest of the world.”

Shashy said reform passing the Congress would take compromise and a lot of luck. But unlike McMahon, Shashy’s skepticism of the reform effort is tinged with optimism.

“It’s definitely possible, but there’s a lot of distance to be covered between where we stand now and meaningful tax reform,” he said.

Meanwhile, Prater and other Senate Finance Committee staff have compiled a series of “option papers,” presenting proposals and perspectives on ways to fix the tax code. The papers are at ww.goo.gl/bcBKcm and include surveys of topics such as “Tax exempt Organizations and charitable giving,” “International Competitiveness,” and “Types of Income and Business Entities.”

Prater expressed confidence that Congress could move forward with a package.

“The tax reform policy machinery is in its best shape since 1986. The committee members could end up voting on the product — the reform product,” he said.

And Sen. Baucus, the Senate Fiance Committee’s Democratic chairman, staked out a preliminary position before Thanksgiving with draft legislation that sets a lower top corporate tax rate than current law. But it also also sets a floor, requiring U.S. companies with foreign subsidiaries to pay a minimum rate.

For now, lawmakers remain in the legislative construction phase, and there’s no telling what form a new corporate tax edifice might take.